Friday, June 13, 2008

Oil Shocks Are NOT Necessarily Inflationary

Oil Shock I: World oil prices almost quadrupled between 1973 to 1975, from $3.50 per barrel in 1973 to $13.50, a 286% jump. Result in Germany? Inflation DECREASED from about 8% to 5% during this period, while U.S. inflation more than tripled from 3.65% in January 1973 (not pictured above) to 12.34% by the end of 1974. Oil Shock II: From 1979 to 1981, world oil prices more than doubled from $15.35 per barrel to $38.34 per barrel. Result? U.S. inflation reached almost 15% in the spring of 1980, while German inflation never got above 6% during the oil shock (see shaded area above).

Bottom Line: The case of German inflation in the 1970s and early 1980s demonstrates that oil shocks are not necessarily inflationary, unless accompanied by "accommodative" (i.e. "easy") monetary policy, like was the case in the U.S. Faced with the same rising world oil prices as the U.S. during both oil shocks pictured above, Germany's inflation was much, much lower than the U.S.

The M2 money supply in the U.S. grew by 25% from 1973 to 1975, and again by 28% from 1979 to 1981, and it was that monetary expansion in the U.S. that caused all prices to rise significantly (including the non-food, non-energy core CPI items, see related post), and not rising oil prices.